Friday, June 7, 2013

The May employment report shed no new light on the state of the labor market. For the past two years, and for the past six months, the private sector has been adding jobs at about a 2% annual pace. Consideriing the huge job losses that came with the Great Recession, that adds up to the slowest recovery in the jobs market in modern times, and it's the source of lots of angst and hand-wringing. Things could be a lot better, but at least jobs are growing. There is no boom or double-dip recession out there, and neither appear likely for the foreseeable future. It's simply modest-to-moderate growth.

But as I've been asserting for a long time, avoiding recession is all that matters when the yield on cash is zero. If the labor market continues to grow at the pace of the past two years, investors who avoid cash are likely to do better than those who hold cash, because the yield on non-cash assets is much higher. Zero-interest cash only pays off if the economy suffers a disruption that reduces cash flow, increases default risk, and/or impairs profits (since any of those is likely to depress the prices of risk assets). As time passes and the economy continues to grow, the cumulative outperformance of non-cash assets will increase the world's temptation to reduce cash holdings, and that will eventually show up as higher prices for risk assets.

The Fed will eventually succeed in reflating the economy, but not by "printing money." Reflation requires convincing the world that holding lots of cash (and relatively safe assets like short-term Treasuries) doesn't make sense. To date, the Fed has been working hard to supply bank reserves to the world in order to satisfy what has proved to be an extraordinary demand for cash and cash equivalents. As the demand for cash declines, the Fed should be able to reverse its Quantitative Easing with no adverse consequences, because it will be trading higher-yielding assets (e.g., notes and bonds) for the cash the public has tired of holding. The key to reversing QE is thus a declining demand for money, and we are seeing the early signs of that in the recent rise in real yields on TIPS and nominal yields on Treasuries (see chart above). Rising yields on relatively safe assets such as 5-yr T-notes and 5-yr TIPS are the flip side of falling prices (i.e., falling demand). Put another way, rising real yields on TIPS are a sign of increased confidence in future economic growth (or decreased pessimism). Increased confidence in the future comes hand in hand with reduced demand for cash and cash equivalents.

But back to the labor market. As the chart above shows, the economy continues to add jobs. Since the low in early 2010, the private sector has created between 6.7 and 6.9 million new jobs, according to the government's two employment surveys. There is no sign that this growth is ebbing or accelerating.

Overall jobs growth has been a bit slower than the growth of private sector jobs, because the public sector has been shedding jobs for the past four years. This is actually a healthy development, since the private sector is generally more efficient than the public sector, and since the public sector had grown like topsy over the past decade or so. A shrinking public sector frees up resources for the more productive private sector, so over time that should boost growth somewhat. We probably haven't seen the end of this shrinkage either.

Private sector jobs growth has been averaging just over 2% a year for more the past two years. This is almost exactly the same pace as jobs growth in the mid-2000s. In a sense, it's business as usual.

The most unusual thing about this recovery is the very slow growth of the labor force over the past four years. Instead of growing about 1% per year (in line with growth in the population), labor force growth has been extremely weak, and has posted only 0.4% growth in the past year. Demographics (e.g., the aging and retirement of baby boomers) can explain some of this slowdown, but it's likely that the large increase in transfer payments since 2008 (e.g., food stamps, social security disability, emergency unemployment benefits) has played a role as well. When compassionate government doles out money to assuage the victims of a recession, it inadvertently acts to retard the recovery because it reduces the incentives to get back to work. It's also likely that the big increase in regulatory burdens in recent years (e.g., Dodd-Frank, Obamacare, EPA rules) has created disincentives for businesses to expand, thus limiting job opportunities and leaving many would-be workers discouraged. Higher marginal tax rates haven't helped either, since they are a disincentive to work and invest. The economy is growing at 2% despite all these headwinds.

Does the Fed really think that buying $85 billion worth or Treasuries and MBS each month and paying for them with bank reserves will change this relatively slow-growth picture? How exactly will more bank reserves lead to more job creation? It's not obvious to me.

As the chart above shows, there is no evidence that the Fed's Quantitative Easing efforts have resulted in any unusual amount of money growth. The M2 measure of the money supply, arguably the best, has grown only slightly faster than 6% per year since the Great Recession. That growth is easily explained by strong money demand: the vast majority of the growth in M2 in the past 4-5 years has come from an increase in bank savings deposits. At the same time, virtually all of the Fed's $2.3 trillion worth of purchases of Treasuries and MBS have gone to support increased currency in circulation and excess reserves. Banks now hold $1.9 trillion of excess reserves at the Fed; they are presumably happy to do so because reserves pay interest and are thus effectively a substitute for T-bills. Banks are still quite risk averse as is the public, since households continue to deleverage. Hardly any of the flood of new bank reserves has been used by banks to increase lending and expand the money supply. Currency in circulation is up more than $0.34 trillion since Q3/08, largely because people all over the world want to hold more dollars under the mattress, so to speak.

This can't go on indefinitely. At some point attitudes toward risk will change, and the demand for safe assets and cash will decline. Bank lending will increase. Money supply growth will increase. Nominal GDP growth will increase. The prices of risk assets will rise further. All of these will be signs that the Fed should begin to reverse QE. As mentioned above, there are already tentative signs of this, and one more non-recessionary jobs report such as today's only makes it more likely that this process is getting underway. I'm reminded of my post last March:

... the biggest risk we all face as a result of the Fed's unprecedented experiment in quantitative easing is the return of confidence and the decline of risk aversion. If there comes a time when banks no longer want to hold trillions of dollars worth of excess bank reserves for whatever reason (e.g., the interest rate the Fed is paying is no longer attractive, or the banks feel comfortable using their reserves to ramp up lending, or the public no longer wants to keep many of trillions of dollars in bank savings deposits), that is when things will get "interesting."

I suspect that the Fed has been engaged in a bit of false advertising, claiming that it is buying billions of Treasuries and MBS in order to lower interest rates and thereby goose the economy. The dirty secret is that monetary policy can't create or stimulate growth, it can only facilitate growth. As I discussed the other day, interest rates are now higher than they were when QE3 started late last year. Paradoxically, rising interest rates are the clearest sign that QE has achieved its real purpose. In reality, all the Fed is doing is satisfying the world's demand for safe assets: exchanging bank reserves for notes and bonds. There's nothing wrong with that, and if they hadn't done this we'd be in a world of hurt—there would have been a shortage of safe money and that could have led to deflation and worse. The Fed has satisfied the world's demand for safe assets, but there is no evidence at all that the Fed's actions have translated into more jobs or faster growth. The economy has been growing all along the old-fashioned way: by adjusting to new realities, by working harder and more efficiently, and by investing more, in spite of all the obstacles. Economic growth and new jobs are not created by adding bank reserves to bank balance sheets.

The issue right now is when the Fed will begin to "taper" its QE program, and whether this will hurt the economy or not. The Fed has suggested that the unemployment rate needs to fall much further before they start to unwind QE, but we're not likely to see a 6.5% unemployment rate anytime soon if current trends continue—it could take another year.

Meanwhile, there seems to be growing unease among FOMC members with the obvious progress the economy is making. It's risky to keep the monetary pedal to the metal year after year when the economy has already demonstrated the ability to create jobs at the same pace as it did in the mid-2000s.

I think this explains why the Fed is trying now to accelerate its transition to an unwinding of QE, well in advance of the economy hitting the targets the Fed had previously proposed. It's a tacit admission that the purpose of QE wasn't really to create more jobs, it was to satisfy the world's demand for safety in uncertain times. Now that the economy has demonstrated the ability to grow for the past four years, and now that the public's demand for safe assets is beginning to decline (witness also the big drop in gold prices in recent months), QE is no longer necessary. Godspeed. It will not be missed. Higher interest rates do not necessarily pose a threat to growth, they are a natural result of growth.

18 comments:

Friedman believed a central bank, when confronted with a sickly economy, low inflation---or zero lower bound---had to buy bonds, and keep on buying bonds until aggregate demand increased. Friedman contended with aggressive QE the economy would first exhibit growth, then higher rates of inflation, and finally higher interest rates. Then the central bank could consider cutting back QE.

Printing money is a good solution, argued Friedman, in cases where there excess capacity, weak demand, and interest rates were very low.

Throw a $100 bill on the ground, and see if economic activity does not pick up. It will pick up, and there will be little or no inflation, as long as there is slack in the economy. If you wave cash at people, you will be surpassed how quickly output can go up.

See Friedman's arguments here:

http://www.hoover.org/publications/hoover-digest/article/6549

True, people now in USA are saving cash, not spending it enough. But with swollen reserves, banks at least have the capacity to lend, and the rising C&I loans levels, and increased commercial and residential property sales, proves that lenders are lending more.

Now, Japan went with sustained QE from 2001-6, and John Taylor (Stanford) gushed about the results. Wrote a paper on his website, thrilled with BoJ's QE. Then the BoJ stopped, and Japan went back to ZLB and has been there ever since.

The key is to sustain QE, well past the 2 percent "ceiling" the Fed has arbitrarily placed on inflation (and even that we are badly below, now at 0.7 percent).

There is no indication that 1 percent, or 2 percent, or 3 percent inflation is a rate most consistent with sustained economic growth.

A real question is whether 2 percent is too low. If you are at 2 percent inflation, and you hit a recession, a central bank suddenly finds that interest rates have dropped into ZLB land. Then a central bank cannot lower rates any more. It is powerless--unless it goes to QE.

The whole world, for the last 30 years, has been trending towards ZLB and lower rates, as major central banks have "fought inflation."

They won that war. But now, they keep fighting that war---like every public agency, they became frozen and are not wiped out by better competitors. They are stuck with their inflation-fighting mode and rhetoric.

We had two choices: Return to higher rates of inflation and interest rates, or support continuous QE (or the this choice: Japanonomics).

The Fed will fail to reflate the US economy other than at the Federal layer, including the military-industrial complex, the medical establishment, Wall Street, and Federal employees -- global competition is the new challenge for America -- Main Street USA will remain mired in economic depression for the balance of the 21st century -- watch and learn...

One thing that you don’t mention when suggesting that TIPS are signaling an increase in demand, is that breakeven inflation (diff nominal yields/TIPS) is actually falling. I think this is somewhat contradictory to your argument that demand is increasing and and that “Rising yields on relatively safe assets such as 5-yr T-notes and 5-yr TIPS are the flip side of falling prices (i.e., falling demand)”.

Rather I read this as real rates are increasing while the world expects prices to fall – i.e. that deflationary forces have the upper hand.

One thing that you don’t mention when suggesting that TIPS are signaling an increase in demand, is that breakeven inflation (diff nominal yields/TIPS) is actually falling. I think this is somewhat contradictory to your argument that demand is increasing and and that “Rising yields on relatively safe assets such as 5-yr T-notes and 5-yr TIPS are the flip side of falling prices (i.e., falling demand)”.

Rather I read this as real rates are increasing while the world expects prices to fall – i.e. that deflationary forces have the upper hand.

“The month of May, and this first week of June, were terrible for many fixed-income investors who have spent the last few years reaching for higher yields. As if it wasn’t bad enough for the millions of Americans scraping by on paltry interest payments, now they face another threat: the loss of principal on their bonds and other fixed-income assets. Consider the damage: mutual funds that invest in long-term United States Treasury bonds lost an average 6.8 percent in May, according to Morningstar, with the loss in principal wiping out years of interest payments.

But that’s not the worst-hit sector. Higher-yielding bonds and fixed-income securities, to which investors have turned in droves in recent years, have suffered even more, especially mortgage-backed securities and emerging market debt, as well as just about anything that uses borrowing to increase returns…..

- Vanguard’s Extended Duration Treasury Index fund was down more than 6 percent in the last month.

- Pimco’s Corporate Opportunity Fund, which invests in a mix of corporate bonds and mortgage-backed securities lost nearly 13.4 percent.

- High-dividend stocks were pummeled. Shares of Procter & Gamble dropped more than 6 percent the last week in May.

“When you get a fundamental shift in interest rates, which doesn’t happen very often, the initial move is always pretty dramatic,” Mr. Cohn said. “It’s a move from a lower rate world to a higher rate world, and people try to get ahead of it.”....

To summarize, I think a significant rise in real yields reflects 1) improved expectations for economic growth, and 2) since inflation expectations have fallen at the same time that real yields have risen, but inflation expectations remain in a fairly normal range, I think this reflects a market that is now less concerned about the Fed "over-inflating" the economy. Higher growth expectations and lower inflation expectations are a very healthy development.

It's also the case that 5-yr TIPS are arguably safe-haven assets, since they are default-free and immune to rising inflation. Since real yields are up significantly and the prices of these securities have fallen significantly, I see that as an indication that the demand for cash, cash equivalents and safe assets has declined. This is perhaps the first real indication that the demand for money is now declining, whereas it has been very strong and rising for the past 4-5 years.

Rates are rising and inflation is falling… Sorry for repeating myself, but I can’t get my mind around that breakeven inflation is falling at the same time as (if) demand is on the rise. But since TIPS are less liquid it might be a temporary thing…

Let's face it, growth of Federalism and its sponsors, including the military-industrial complex, the medical establishment, Wall Street, and Federal employment, portends the end of QE in its various forms -- the USA is all about saving Federalism from itself -- everyone excluded from the beneficiaries listed above should be under cover living in fear of the status quo -- Federalism will eventually eviscerate all sectors of the US economy except the Federally sponsored sectors listed above in order to save Federalism from itself -- the way of Main Street USA is likely to go the way of the American Indians -- most Americans should be terrified of US economic growth, which is happening at their peril -- the only good news is that accredited investors will win big in the 21st century -- everyone else is headed for destitution as real working wages in the US regress to global norms over the balance of the 21st century...

PS: I implore Americans to do whatever is necessary to acquire world-class skills that earn premium wages that convert into dividend and rent-earning equities over a lifetime -- setting a course to remain in the 99% crowd in America is a one-way ticket to destitution...

Scott ... If the tapering of QE were to occur against the backdrop of reduced demand for safe-haven cash, where would that put you on oil prices? In theory it seems to me the whole exercise would be a wash, no? (Less safe-haven cash demanded, less supplied.) That would leave the commodity-price backdrop basically unchanged. Perhaps gold would fall some due to reduction of end-of-world risk, but I'm not sure the same dynamic would extend to oil -- especially since oil has a GDP component in its demand calculus that gold doesn't have.

Kgaard: Re oil. I think you're right. In theory, if the Fed reverses QE in line with a decline in the demand for cash, cash substitutes and risk-free assets in general, there should be no downward pressure of a monetary nature on commodity prices. I think gold would tend to decline in such an environment, because the uncertainty surrounding monetary policy would decline.

Scott, I came across an intersting data stream that purports to track the probability of deflation (published by the Atlanda Fed as linked below) -- the indicators seems to report that the risk of deflation is rising -- any commentary from Scott or others would be helpful -- more at:

What we have been witnessing is the Great Phony recovery, lead by deficient spending and FedZero...

Declining GNP and standard of living, are also failing and shall continue until the yoke of Socialist/Commie movement of Alinsky/Ayers are permanently end ...

The long length of taxes upon taxes, regulations designed to determine whom will enter the market place and political corruption, are now the determining factors of who becomes an ongoing concern...

There is no longer a single element of "free marketplace" left as we once knew it...

You can publish charts after charts, you can debate micro economic theory until you turn blue; the fact remains that virtually every action by individuals require approval by a Ministry of Government...

The consequences are here already; as capital has moved off shore to more friendly environments and will continue to do so, unless something is done and soon..